When should termination settlements be tax-free?

In
theory, the first £30,000 of an employee’s severance award could be paid gross.
If only it were that simple

Many
employers will be familiar with negotiating a settlement with a departing
employee. The question which often arises is whether the termination payment
made by the employer is taxable.

Section
148 of the Income and Corporation Taxes Act 1988 states that the first £30,000
of any payment received "in connection with the termination of a person’s
employment" is exempt from tax.

This
is attractive because an employer who does not have to account to the Inland
Revenue for tax on a payment to an employee can, if it wishes, afford to pay
more to the employee, thereby increasing the incentive to agree to the
settlement.

However,
the sting in the tail comes with the fact that the £30,000 exemption applies
only to termination payments that are not otherwise taxable under section 19 of
that Act which states that emoluments in respect of any office or employment
are subject to income tax.

As
the definition of "emoluments" here is wide enough to cover a
termination payment, it has always been necessary for the employer to consider
the payment should be subject to tax. 
Generally a view has been taken that, unless the termination payment is paid
pursuant to a payment in lieu clause in the contract of employment, it would be
unlikely to be taxable. 

However,
the recent High Court case of Richardson (Inspector of Taxes) v Delaney, June
2001, ALL ER (0) 74 suggests that the position is more complicated. 

Delaney’s
contract of employment gave his employer the option of either giving 18 months’
written notice of termination or terminating the employment immediately and
paying 18 months’ salary in lieu of notice.

On
1 December 1995 he was given notice that his employment would be terminated but
no notice period was specified. He was put on garden leave until further notice
and continued to be paid.

The
employer then wrote saying that his employment would terminate on 28 December
and offered compensation for that termination. He negotiated a higher figure
and his employment terminated on 28 December.

When
the Inland Revenue sought to recover tax on the compensation payment, Delaney
argued that the payment was not an emolument but compensation for a breach,
namely that his employer had two lawful options for terminating the contract –
either to give 18 months’ notice or to pay in lieu of 18 months’ notice – and
had done neither. If he had not negotiated an acceptable sum to compensate
himself for the breach, he would have had to sue for breach of contract.

The
High Court noted that Delaney’s employer had not used either of the two methods
of termination provided by the contract. Neither side, however, had acted as if
the employer was in breach in purporting to terminate the contract in the way
it did. If the employer had terminated the contract by either of the above two
methods, any payments to Delaney would have been taxable. In the circumstances
therefore, given that no breach could be identified, the payment he had
received should be taxable in full as an emolument under section 19.

This
is likely to mean that more termination payments negotiated before termination
of employment will be taxable. In effect, unless there is a breach (such as a
summary dismissal with a payment in lieu where there is no contractual
provision allowing the employer to do that) or the termination payment is
genuinely ex gratia, the risk is that the £30,000 exemption will not be
available.

Key
points


More termination payments may be subject to tax in full.


Consider whether a proposed payment is likely to be so taxable.


Consider whether a tax indemnity or prior Inland Revenue clearance is
appropriate.

By
Sarah Lamont, a partner at law firm Bevan Ashford

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